(Beijing) â€“ How did a simple system glitch slip past layers of supposedly strong fail-safe mechanisms and rock the country's entire securities market?
This is the question that many people have been asking since a trading error by Everbright Securities directly led to erroneous transactions worth billions of yuan on August 16. The A-share index surged as a result, then fell the same day when the firm admitted its mistake.
This is "an extreme case without any precedent since the establishment of the A-share market," the China Securities Regulatory Commission (CSRC) said in a press briefing. It is still looking into the matter. No human error was found.
But it is clear that the fiasco could have been prevented â€“ if Everbright was more careful with the design of its trading system and if it had not intentionally skipped crucial steps regarding risk control to beat competitors by a split second in placing orders.
Everbright has suspended Yang Jianbo, head of its Strategic Investment Division (SID), which is directly responsible for the mistake. Soon after, Xu Haoming resigned as the firm's president.
Founded in 2010, the SID was a rising star in Everbright. It earned 124 million yuan in profit for the company in 2012, a 33-fold increase from the previous year.
The glory ended on August 16. Within two seconds at 11:05 a.m., its trading system generated 26,082 buy orders, sweeping clean all stocks for sale on the main board and pushing up the Shanghai Composite Index by 5.62 percent from its closing level the previous day.
It happened because the order-generating system was programmed to resend orders if it did not receive feedback from the order execution system in 150 seconds, an Everbright executive said.
In itself, the repetitive operations are unlikely to cause much trouble because they need to pass through layers of examination and risk control before being sent to the stock exchange and executed.
But all of these layers failed. By the time the morning trading session closed, Everbright had offered to buy stocks worth 23.4 billion yuan, and shares worth 7.3 billion yuan were actually bought. Traders canceled the rest, resold some of the stocks and shorted the stock index future, narrowing the firm's risk exposure by the end of the day to 196 million yuan.
When the traders realized the system had sent out a huge amount of unintended orders, "new orders were still being generated and there was no way to stop them," a source with firsthand knowledge of the situation said.
"The traders had to pull out the Internet cable and also the power cord" to shut down the computers, he said.
The buy orders mistakenly placed by the system had far exceeded the limit of 80 million yuan that Everbright said it allocated to the SID for that day. Individual traders are in no position to change the ceiling independently because doing so requires permission from several departments, an executive of a securities firm said.
As it turned out, the SID's trading system, comprised of a self-designed order-generating system and an order-execution system developed by Shanghai Mecrtsoft Tech Co. Ltd., lacks a crucial component that prevents orders larger than a preset limit from being executed.
Everbright and Mecrtsoft have blamed each other for not building the component into their part of the trading system.
The main reason for the mistake, the brokerage firm said, is the order-execution system failed to exercise effective control over the amount of capital that could be used for trading.
Mecrtsoft has declined to comment. A source inside the firm said its order-execution system was meant to be only a passageway linking traders with the stock exchange. The company also develops an order-generating system capable of shutting out larger-than-expected orders, but Everbright did not buy it, he said.
Setting a limit on a transaction amount is not enough. A trading system should also be able to verify the validity of buy and sell orders by comparing them against the resources a trading company intends to use, such as its margin deposit with a stock exchange, said a technician from Hundsun Technology Inc., a competitor of Mecrtsoft.
"Whether transaction orders go through a verification stage can tremendously affect the speed of placing an order," a computer engineer designing high-frequency trading systems said.
Without the verification stage, it takes less than half of the time it normally requires to place an order with an exchange, he said. In arbitrage transactions, opportunities are extremely short-lived, he said. "Differences are made in milliseconds."
Everbright's trading system does not have the verification stage, a source who knows the system said.
Neither the securities firm nor the CSRC has addressed this issue. What many traders in other securities firms know for sure, however, is that they were almost always outpaced by Everbright when trying to buy the same stock.
The missing risk-control component in the trading system is only part of the story. The investigation found that Everbright did not include the SID in its centralized risk control system, which should cover the entire company's transactions. In other words, the SID's transaction orders can go directly to the stock exchange without being checked by the central risk control system.
"If such a huge amount of buy orders went through the central risk control system, there was no way they could have been sent out" to the exchange, a source on the investigation panel said.
He also said that most securities firms in the country give privilege to their proprietary trading department so they can place orders ahead of those managing clients' money.
Skipping the central risk control system would significantly reduce the amount of time needed for a transaction, he said. In this business, even a microsecond counts.
Everbright was not the only securities firm trying to take advantage of the time gap. The others just have not been caught, several industry insiders with knowledge of the matter said.
Blame Game
Some critics have also questioned whether the Shanghai Stock Exchange was also to blame, at least for being negligent, because there was reason to believe that Everbright could not honor all of the transaction orders it submitted.
Under the CSRC's regulations, a securities firm cannot hold stocks and securities derivatives worth more than its net capital. Everbright placed orders worth 23.4 billion yuan, but its net capital last year was only 13.1 billion yuan.
Critics also say that the settlement mechanism does not mean any real restraint against abnormal orders.
Unlike retail investors, brokerage firms' securities transactions are settled on a net basis one day after the trading. Because buy and sell orders cancel each other out, securities firms often deposit only a fraction of their transaction amount, which is called settlement provision, with China Securities Depository and Clearing Co., Ltd. (CSDC), the settlement agency for exchange-market transactions.
The CSDC can punish securities firms for not having enough provision for settlement, but it rarely has.
As seen in Everbright's case, this settlement mechanism has little supervision over institutional traders' buying operations. In theory, as long as there are sellers, an institution can buy as many securities as it wants, an analyst familiar with the mechanism said.
Had all of Everbright's unintended buy orders met sellers, the stock exchange would find itself in a position where it must arrange for the firm to be liquidated to pay for those transactions, the analyst said.
A regulator said the exchange did not do anything wrong. "The current settlement provision system used by the exchange to bind member institutions aligns with the international norm," but that does not mean the securities firms do not need to have an effective risk control system themselves, he said.
Also, the electronic trading system used by the Shanghai Stock Exchange is the most advanced system in the world, the regulator said, and it is designed to be capable of identifying trading abnormalities in real time and taking action to prevent loss.
That said, he added, it is apparent that the bourse "lacks experience in dealing with extreme cases."